The Duffey Law Firm Blog

One of the issues that we see with the discussion of the proposed Trump Tax Reforms is that many clients assume that Tax Reform will mean lower taxes. If Trump and the Republicans lower taxes, how could that be a bad thing? Under all circumstances, wouldn’t lower taxes have a positive impact on all taxpayers? And isn’t that especially true for affluent tax payers? As any student of tax law in the United States can attest, tax reform doesn’t always mean lower taxes for all and of course, in the past, tax reform has led to some unintended consequences.

Takeaways from Trump Tax Reform Update #2

Most estate planning trust agreements over at least the last 15 years include formula funding language which assumes an estate tax

If the estate tax is repealed, the formula funding language may disinherit surviving spouses

This issue affects most if not all married couples but the situation could be acute in second marriages due to issues of funding trusts for children of first marriages

One simple solution is to review and revise estate planning agreements – but action is required

At the time of this writing, the tax reform legislation is not yet written, and the discussion points that have been disseminated have very few details. However, for purposes of this update, let’s focus on estate taxes and related transfer taxes. In order to keep this update reasonably brief, we will keep the focus on points of significance and avoid delving too deeply into the maze of complications that currently exist in our tax code, regulations, rules and laws. Here are the key points that everyone with estate planning documents like wills and trusts should know:

Quick Overview of Current Transfer Tax System

OK, really briefly, one needs to keep in mind that our tax system currently operates in related but often separate taxing regimes. First, of course we have the income tax system. This is meant to capture income as it is earned and apply the tax rules to income, capital gains (losses), dividends, etc. Next we have the estate tax which taxes wealth as it transitions after death from one taxpayer (decedent) to one or more taxpayers (spouses or children) or entities (like trusts or charities). In conjunction with the estate tax we have what is known as the Generation Skipping Transfer Tax (GSTT for short). This tax is intended to keep the very wealthy taxpayers more or less honest with respect to the estate tax. The way the GSTT works (in very brief) is that when a taxpayer transfers assets to individuals that are more than one generation removed from the decedent (like grandchildren or great grandchildren) a transfer tax is imposed. Why is this necessary? Because without the GSTT wealthy individuals could transfer substantial assets to grandchildren or even great grandchildren and the government would “miss-out” getting the estate tax that would normally be imposed on assets as they pass from generation to generation. In other words, the government’s ideal situation is to tax assets at each generational level as the assets pass from the estate patriarch to his son or daughter, from that son or daughter to their children (the third generation or grandchildren of the patriarch) and so on.

Without the GSTT, the wealthy patriarch could pass millions in assets to grandchildren or even great-grandchildren and the IRS would “miss-out” on taxing the intervening generational levels.

Finally, we must consider the Gift Tax. Essentially, the Gift Tax may be viewed as a “backstop” to the estate tax. The gift tax is imposed on transfers of wealth during life, while the estate tax is imposed on transfers that occur between a decedent (post death) and his or her heirs. Consider the possibility of a wealthy person, on or nearly on his or her deathbed. Instead of waiting until after the taxpayer passes to make a transfer, he or she makes substantial gifts immediately prior to death (sometimes accomplished by a power of attorney or under a trust). Without the gift tax, that transfer would not be impacted by any transfer tax (presuming the GSTT was not involved, e.g. a gift to a child rather than a grandchild).

Thus, the transfer tax system is essentially made up of the estate tax (taxing transfers on death) the generation skipping transfer tax (taxing transfers to beneficiaries more than one generation below the decedent or donor) and the gift tax which taxes transfers made during the donor’s lifetime.

How Exemptions Work in the Transfer Tax System

With the basic explanation above, consider the fact that over time Congress has allowed for a certain amount of wealth to transfer without imposition of one or more of the transfer taxes. Currently, in January 2017, a decedent can pass up to $5,490,000 without incurring any estate tax. The exemption is currently (though not always) the same for the GSTT and for the Gift Tax. Thus, a donor could make a lifetime gift of $5,490,000 to a donee, file a gift tax return, elect on that tax return to utilize the donor’s lifetime gift tax exemption and neither the donor nor the donee would pay any gift tax on the $5,490,000 gift. Note, these exemptions do not “stack.” That is, a tax payer cannot make lifetime gifts of say $5,490,000 and also use the taxpayer’s estate tax exemption at death. If the taxpayer uses the gift tax exemption during his life for a lifetime gift, the estate tax exemption would be “used up” or in other words not be available for a post death transfer (it was used or consumed by the utilization of the gift tax exemption).

Shifting Sands – Transfer Tax Exemptions Over The Years

As if all the above is not complicated enough (keep in mind for purposes of brevity, probably 95% of the complications of the transfer tax system are not discussed herein), there are many more complications that your estate plan contemplates and hopefully resolves.

Pressing on, as even many casual observers of taxes and estate tax know, the Republican Party has been doing everything they can to eliminate the estate tax and other transfer taxes over the past several years. In fact, in 2001, President George W. Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). One of the key elements of that law was the “repeal” of the estate tax. However, the law did not simply revoke the estate tax. Rather, it phased-out the estate tax over ten years. The estate tax exemption went from $675,000 in 2001, to $1,000,000 in 2002 & 2003 up to $3,500,000 in 2009, then the estate tax was eliminated in 2010. Unfortunately for many affluent taxpayers, in 2011 the state tax (and GSTT) came back with a lower exemption amount of only $1,000,000. Yes, my friends, the Estate Tax Repeal was for only one year 2010 and it came back in 2011 under EGTRRA to an amount much lower than in 2009. No wonder generally speaking voters have a disfavorable view of Congress.

Why History Is Relevant to Today

The reason why the above is important for everyone to understand in relation to the current Trump Tax Reform Proposal is simply this, if the estate tax is eliminated, even if only for a year or two or even four, it could have a major impact on your family and that impact may not be a good one! Here’s why; estate planners over the past decade have had to deal with a shifting and changing dollar amount on the estate tax exemption. In other words, for clients passing in 2009, if the exemption amount was $3,500,000 and the client’s estate was worth say $5,000,000 the estate would only have an estate tax issue with regard to $1,500,000. Note, when we say “only” keep in mind the tax rate in 2009 for those assets would have been 45% or $675,000!

For many if not almost all married clients over the last decade or so, estate planning attorneys commonly utilized the concept of a family trust (or “bypass trust,” so called because it “bypasses” the estate tax by utilization of the estate tax exemption) in combination with a marital trust. The reason was that the marital trust deferred estate taxes on the death of the first spouse. In other words, any assets passing to a surviving spouse could be sheltered from estate taxes on the passing of the first spouse, thus at least the estate tax could be deferred until the death of the surviving spouse. The reason for this is the fact that married couples can pass any amount of assets from spouse to spouse without imposition of an estate tax.

Thus, if the exemption amount or lifetime exclusion amount was say $3.5 million, and the client had an estate valued at $5 million, the typical plan would create two trusts on the taxpayer’s death, a family (or bypass trust) and a marital trust. Here’s the important part: the trusts typically have a formula which directs something to the effect of the following: “whatever amount that can pass free of estate tax will fund the family (or bypass) trust, and the balance of assets will fund the marital trust.”

Why the formula language? Because the exemption amount has fluctuated so often over the past several years, estate planners and their clients could never be certain what the exact amount that could pass free of estate tax would be at the time of the client’s passing.

So, as in our example, if taxpayer had an estate worth $5 million, with an exemption amount of $3.5 million, the family trust (bypass trust) would be funded with $3.5 million and the balance of $1.5 million would fund the marital trust.

Here is why almost all taxpayers will need to review and perhaps change their current estate planning documents. If the Trump administration eliminates the estate tax, in the example above, all $5 million of the taxpayers assets will go into the family trust. That means, ZERO will go into the marital trusts. You may be able to hear the gasps and wailing and mashing of teeth from where you are sitting right now!

What this means, is that there is a very real possibility that many surviving spouses will not get what they are expecting, and perhaps what they should be getting simply because of how these formula clauses will work under the new facts of a world with no estate tax.

Out of the Pan and Into the Fire

Now, think about this for a moment. Think about the situation where an affluent couple, husband and wife, set up their estate plan with their estate planning attorney, perhaps as recently as even just a couple of years ago, or even just last year. Assume the couple each had prior marriages and the husband has a net worth of approximately $20 million. Based upon actuarial probabilities, we generally assume the husband will predecease the wife. It could well be that under the circumstances, the clients and their estate planning attorney assumed that the family trust (bypass trust) would be for the benefit of the children of the husband’s first marriage (either primarily or perhaps even exclusively for their benefit). However the other part of that assumption was that a substantial amount of assets would fund the surviving spouse’s trust (the marital trust).

Based upon the formula, the amount that would go into the family trust would only be approximately ¼ of the husband’s net worth ($5.5 million). Under the then applicable funding clause in 2016, that is exactly the result that the clients would get. The family trust would be funded with approximately $5.5 million and the marital trust would get approximately $14.5 million. Presumably, the surviving spouse’s lifestyle would be preserved as the marital trust would typically provide 100% of the income to the surviving spouse and may have allowed for invasion of principal as well (for things like health, support and maintenance).

Under a new reality, if the Trump administration eliminates the estate tax, the same exact formula language in the trust would have drastically different results. If there is no estate tax, the formula clause will cause all $20 million to go into the family trust and ZERO would go into the marital trust. Imagine the shock to the surviving spouse. To go from a lifestyle enabled by a $20 million dollar net worth, to a $14.5 million dollar marital trust to essentially ZERO!

It’s important for taxpayers to realize that this issue may impact many if not most of our married clients, however the situation could be even more acute for couples with second marriages. The reason is that in situations of second marriages, sometimes the estate plan contemplates funding trusts for the benefit of children of the prior marriage. If a formula clause drives the determination on funding to the bypass or family trust, there is a very real possibility that the surviving spouse may be disinherited.

Of course many estate planning documents have many variables and no two trusts are exactly the same. Nonetheless, everyone with estate planning documents should at the very least review their documents and determine if they still work for the family in light of new the proposed new tax laws.

Action Steps

For many married couples the solution should be fairly simple. Review your estate plan with your estate planning attorney and make certain that your estate planning documents (typically trusts) have a provision for the possibility of the elimination of the estate tax. For example, what we are recommending to many clients who are currently doing their planning is to have a “Toggle Clause” which will provide directions for funding in the event of an estate tax or no estate tax. The Toggle Clause says something like; “if there is in effect an estate tax at the time of my passing, then the Trustee will fund the family trust (bypass trust) with X and the marital trust with Y. If at the time of my passing there is no estate tax in effect then the Trustee will fund the family trust with A and the marital trust with B.” Of course, the clients will be the ones making the choices as to the appropriate amounts to fund the family trust and the marital trusts. Since none of us know when we will pass, and since at this time we have no clear direction on where the estate tax will end up, we recommend that everyone modify their estate plans with some form of flexibility as to either an estate tax regime or a no estate tax regime.